The annual rise in deposits to the Cypriot banking system is improving the banks funding structure, raring agency Moody`s said on Thursday as deposits rose by €3 billion in 2016.

Deposits in the Cyprus banking system in 2016 rose for the first time since the 2013 banking crisis that saw unsecured deposits converted to equity to save the island`s largest lender, Moody`s said a Credit Outlook issued Thursday.

“The increase in deposits was driven by more stable domestic deposits and is credit positive because it improves banks’ funding structures. It also points to households’ increased capacity to service their high levels of debt, a significant portion of which is distressed,” the agency said.

Moody`s noted the €3 billion increase in deposits in 2016 (see Exhibit 1), with total deposits amounting to €49 billion, the highest level since July 2013, “indicates improved funding conditions in a system where depositor confidence remains fragile following losses in the country’s March 2013 banking crisis.”

“The improvement reflects Cyprus’ solid economic growth, which we forecast at 2.7% for 2017, lower unemployment and the conclusion of its Economic Adjustment Programme in March 2016,” it said, adding these factors have partly restored depositor confidence, leading to the gradual return of mattress money (i.e., deposits withdrawn from the Cypriot banking system).

Deposits from Cypriot and other euro area residents, particularly corporates from Greece, are driving the growth, with their deposits rising to the highest levels since May 2013 (two months after the depositor bail -in and imposition of deposit controls), Moody`s added.

Protracted bank balance sheet rehabilitation
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The agency noted it expected households’ improved economic conditions to improve their capacity to service their high debt.

“Nevertheless, Cypriot banks’ balance sheet rehabilitation process will be lengthy because of the long cure periods for restructured loans before they are reclassified as performing, and substantial distressed debt that has not been restructured yet,” it added.

Furthermore, Moody`s pointed out that the limited recoveries from asset sales because of the low volumes the real estate market can currently support and the difficulty of changing Cypriot households’ poor borrowing culture, indicated by a relatively high percentage of restructured retail loans that present arrears, will also prolong banks’ balance sheet rehabilitation.

Noting that the issuance of Tier two debt by Bank of Cyprus in January – the first since the 2013 crisis – manifests improving creditor confidence, Moody`s warns however that depositor sentiment remains fragile, and although not our expectation, a weakening in the banks’ solvency would likely spark deposit outflows.